All Things China

Market Commentary, January 7, 2016

Even by rough-and-tumble standards, China had another bad day on Thursday. Another trading halt was implemented following a 7% drop within 29 minutes for one of its exchanges, of which China has several. The Hang Seng China Enterprises gauge of mainland shares listed in Hong Kong tumbled 4.2 percent, its lowest close since October 2011. The Hang Seng Index dropped 3.1 percent. And, the Shanghai Composite Index tumbled 7.3 percent before trading was suspended. As of 9:30am CST European stock markets are down 1.5 to 2% after being down in excess of 3%. S&P futures were down dramatically this morning, but cooler heads once again stepped in and the S&P 500 has recovered to being down just 0.7%. Once again, US Treasuries are trading positive. This is why we diversify.

So, what’s happening?

China’s central bank, People Bank of China (PBoC), cut key interest rates and depreciated its currency to levels not seen since 2011. Normally, that is good news for China as it serves as a stimulus to increase the growth of the economy. However, these moves actually spooked already jittery investors into thinking things are worse than they are. Add in new stock exchange controls and people raced to sell at the opening, closing one of its markets and turning in another bad day for the others.

Why are other stock markets declining?

Despite being technically considered an emerging market; China is the world’s second largest economy. As we have discussed, China has been purposefully trying to transition from an unsustainable centrally managed economy to a consumer based economy. The consumer accounts for approximately 70% of the U.S. economy. The inverse applies in China. Prior to this transition, the Chinese government implemented top-down major investments, which made it the major consumer of commodities. The benefactors of this were, primarily, other emerging market economies that sold commodities to China and, secondarily, other economies that sold other goods and services to China. This included many developed countries.

For developed countries, such as the U.S. and most of Europe, China’s slowdown can hurt in three key ways.

Weaker global trade and a slowing global economy – This is the big fundamental concern. As such, commodity prices are falling again today, including oil. However, as exhibit 1 highlights, the U.S and many other developed countries have manageable direct exposures to China. Surprising to many, the U.S. is a relatively closed economy with only 9% of GDP tied to exports, in general, and a much smaller amount to China.

Financial market contagion – When human nature takes over and fundamentals are discounted or outright thrown out the window, all investments tend to correlate and go down (or up) in sympathy. This is clearly a concern.

Hit to confidence – Similar to a contagion or sympathy effect, a hit in investor confidence is hard to quantify or forecast. However, the U.S. consumer, which accounts for 70% of the U.S. economy, is in good shape. Employment numbers are generally good (exhibit 2), consumer net worth levels have recovered beyond pre-recession highs (exhibit 3), consumer debt service levels are very manageable (exhibit 4), and consequently consumer sentiment levels (exhibit 5) are healthy. Fundamentals in the U.S. point to a continued slow growth expansion.

Exhibit #1

Source: JP Morgan

Exhibit #2

Source: JP Morgan

Exhibit #3

Source: JP Morgan

Exhibit #4

Source: JP Morgan

Exhibit #5

Source: JP Morgan

Didn’t This Happen Before?

Yes. The Chinese stock market significantly declined last summer over the same concerns. (Chinese regulators implemented a variety of controls to curb the panic when that occurred, such as installing a selling ban on major investors. Elements of that ban were set to expire this week. With the sell-off on Monday, regulators were reported to have extended the ban.) Similarly, global stock markets sold off following that episode. Déjà vu. The Chinese stock market will continue to be volatile with concerns over its slowing economy and technical stock market issues (i.e., market halts).

Exhibit #6

Source: Bloomberg

What Does This Mean?

The Chinese economy is not going into a recession. The global economy is not going into a recession. In fact, the U.S. nearly always leads a global recession. And, the U.S. economy is not going into a recession. We believe that the global economy will continue to grow slowly, but that growth may be more balanced than in recent years with other developed economies catching up to the U.S. However, with continued concerns over just how robust growth is or is not in China and with several other geo-political issues, volatility will return to more historical levels.

The Federal Reserve has a dual mandate for healthy employment and price stability (i.e., inflation). Combined with the fact that inflation should remain low and that the U.S. Federal Reserve is keenly focused on global market stability, we believe the likelihood that the Fed raises interest rates multiple times this year as low. From an investment standpoint, we have been underweight international and emerging markets specifically.

We will continue to watch events as they unfold and provide updates as warranted.

Note:The content of this article is for guidance and information purposes only and is not intended to be construed as advice. Information provided is not intended to provide investment, tax, or legal advice.